Monetary Policy Drivers of Bond and Equity Risks John Y. Campbell, Carolin Pueger, and Luis M. Viceira Harvard University, University of British Columbia, and HBS March 2014 Campbell, Pueger, and Viceira (2014) Bond and Equity Risks March 2014 1 / 34
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Monetary Policy Drivers of Bond and Equity Risks long stocks and short bonds)....Understanding correlations requires an understanding of the nature and causes of asset returns. Bridgewater
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Monetary Policy Drivers of Bond and Equity Risks
John Y. Campbell, Carolin Pflueger, and Luis M. Viceira
Harvard University, University of British Columbia, and HBS
March 2014
Campbell, Pflueger, and Viceira (2014) Bond and Equity Risks March 2014 1 / 34
Motivation Background
Changing Risks of Treasury Bonds
US Treasuries are viewed differently today:I “Inflation risk premium” in 1980sI “Anchor to windward”or "safe haven" in 2000s.
Treasuries comoved positively with stocks and the economy in the1980s, negatively in the 2000s.
Important implications for portfolio construction and asset pricing:I Bonds hedge stocks in endowment portfoliosI Equity investing is riskier for pension funds with fixed long-termliabilities
I Increased default risk for firms with long-term liabilitiesI Term premium and average yield spread are likely to be lower.
What has caused this change?1 Changes in monetary policy?2 Changes in macroeconomic shocks?
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Motivation Background
Changing Risks of Treasury Bonds
Over the past decade, the correlation of stocks and bonds has remainedpersistently negative (causing big problems for pension funds that areessentially long stocks and short bonds)....Understanding correlationsrequires an understanding of the nature and causes of asset returns.
Bridgewater Associates, LP, 2013, Recent Shifts in Correlations Reflect theDrivers of Markets, Bridgewater Daily Observations
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Motivation Background
Changing Beta of US Treasury Bonds
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Motivation Our Contribution
This Paper
Model output gap, inflation, and policy rate in canonical NewKeynesian framework.
Endogenize bond and stock returns to match second moments:I Use habit formation and stochastic volatility of macro shocksI Combine modeling conventions of macroeconomics and asset pricing(while trying not to create a “mutant toy” that both fields dislike.)
Calibrate model to three monetary policy regimes.I Pre-Volcker (1960.Q1-1979.Q2): Accommodation of inflationI Volcker-Greenspan (1979.Q3-1996.Q4): Aggressive counter-inflationarypolicy (Clarida, Gali, and Gertler 1999)
I Increased Transparency (1997.Q1-2011.Q4): Monetary policypersistence and continued shocks to inflation target.
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Motivation Literature
Related LiteratureEmpirical time-variation in bond risks: Baele, Bekart, andInghelbrecht (2010), Viceira (2012), David and Veronesi (2013), Campbell,Sunderam, and Viceira (2013), Kang and Pflueger (2013).Affi ne term structure models with macro factors: Ang and Piazzesi(2003), Ang, Dong, and Piazzesi (2007), Rudebusch and Wu (2007).Asset-pricing implications of real business cycle models: Bansaland Shaliastovich (2010), Buraschi and Jiltsov (2005), Burkhardt andHasseltoft (2012), Gallmeyer et al (2007), Piazzesi and Schneider (2006).Term-structure implications of New Keynesian models: Andreasen(2012), Bekaert, Cho and Moreno (2010), van Binsbergen et al. (2012),Kung (2013), Palomino (2012), Rudebusch and Wu (2008), Rudebusch andSwanson (2012).Monetary policy regime shifts: Clarida, Gali and Gertler (1999, 2000),Boivin and Giannoni (2006), Rudebusch and Wu (2007), Smith and Taylor(2009), Chib, Kang, and Ramamurthy (2010), Ang, Boivin, Dong, and Kung(2011), Bikbov and Chernov (2013).
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Motivation Road Map
Road Map
A New Keynesian asset pricing model
Data
Estimating monetary policy rules in three regimes
Model calibration to three monetary regimes
Counterfactual analysis of bond and equity risks
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Model Overview
Model Overview
“A standard New Keynesian model has emerged”(Blanchard and Gali2007):
I Euler equation is New Keynesian equivalent of Investment and Savings(IS) curve
I Phillips Curve (PC) with both forward-looking and backward-lookingcomponents captures nominal rigidities and productivity shocks
I Monetary Policy (MP) rule follows a Taylor (1993) rule withtime-varying inflation target.
Stochastic discount factor (SDF) with habit formation generatesEuler equation and prices stocks and bonds:
I Risk premia increase during recessions, consistent with the empiricalevidence on stock and bond return predictability (Fama and French1989).
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Model Euler Equation (IS Curve)
SDF Implies Euler Equation
For SDF Mt+1 and gross real one-period asset return (1+ Rt+1),
1 = Et [Mt+1(1+ Rt+1)] .
Household optimization:
Mt+1 =βU ′t+1U ′t
.
Assuming no risk premia on short-term nominal interest rates:
it = rt + Etπt+1.
Euler equation for nominal T-bill (ignoring constants):
lnU ′t = (it − Etπt+1) + lnEtU ′t+1.
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Model Euler Equation (IS Curve)
Modeling Marginal UtilityFor preference parameter α and heteroskedasticity parameter b > 0,assume analytically tractable form:
lnU ′t = −α(xt − θxt−1 − vt ) (1)
Vart (lnU ′t ) = α2σ2(1− bxt )Current and lagged output gap affect level of surplus consumption:
I Habit formation preferences of Campbell and Cochrane (1999) producedesired properties for SDF.
I Empirically plausible: Stochastically detrended log consumption andthe log output gap 90% correlated.
Output gap negatively affects volatility of surplus consumption andhence marginal utility:
I Countercyclical volatility of asset returnsI Countercyclical risk premiaI Campbell and Hentschel (1992), Calvet and Fisher (2007), Campbelland Beeler (2012), Bansal, Kiku and Yaron (2011), Bansal, Kiku,Shaliastovich, and Yaron (2014)
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Model Euler Equation (IS Curve)
Output Gap and De-Trended Consumption
05
1015
Log
Det
rend
ed C
onsu
mpt
ion
(%)
10
50
510
Log
Out
put G
ap (%
)
60 70 80 90 00 10Year
Log Output Gap (%) Log Detrended Consumption (%)
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Forward- and backward-looking Euler equation captures thehump-shaped output gap response to shocks (Fuhrer 2000,Christiano, Eichenbaum, and Evans 2005).
Taylor (1993) rule with the Fed funds rate as policy instrument(Clarida, Gali, Gertler 1999, Rudebusch and Wu 2007).Fed funds rate adjusts gradually to target.Fed funds target increases in the output gap xt and the inflation gapπt − π∗t .Changes in central bank inflation target π∗t are unpredictable:
I Dynamics of π∗t consistent with persistent component in inflation andnominal interest rates (Ball and Cecchetti 1990, Stock and Watson2007).
I Persistent inflation target shifts term structure similar to a level factor(Rudebusch and Wu 2007, 2008).
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(1− bxt−1) .Common stochastic volatility for all shocks makes model tractableand generates time-varying risk premia.
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Model Modeling Bonds and Stocks
Modeling Bonds and Stocks
Solve for nominal bond returns using Campbell and Ammer (1993)exact loglinear return decomposition
r $n−1,t+1 − Et r $
n−1,t+1 = A$,nut+1.
Model stocks as levered claim on log output gap (Abel 1990,Campbell 1986, 2003): dt = δxt .
Solve for equity returns using Campbell and Shiller (1988) loglinearapproximation
r et+1 − Et r et+1 = Aeut+1.Solve for the nominal bond CAPM beta, and the volatilities of stockand bond excess returns.
I The model is ready to drive!
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Data and Summary Statistics Monetary Policy Regimes
Monetary Policy Regimes
Divide sample in three subperiods:1 Pre-Volcker [1960.Q1-1979.Q2]2 Volcker - pre-1997 Greenspan [1979.Q3-1996.Q4]3 Post-1996 Greenspan - Bernanke [1997.Q1-2011.Q4]
Subperiods 1 and 2 identical to Clarida, Gali, and Gertler (1999)I Post-Volcker Federal Reserve counteracts inflation
Superiod 3 is newly identified in this paperI Increased transparency and gradualismI Publication of FOMC transcriptsI Not a single dissenting vote at FOMC meetings since 1997I Greenspan and Bernanke argue for cautious monetary policy in light ofincreased uncertainty about the effects of monetary policy
I Characterized by negative bond beta
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Data and Summary Statistics Data
Data
GDP in 2005 chained dollars and GDP deflator from Bureau ofEconomic Analysis.
Potential output from Congressional Budget Offi ce.
Federal funds rate from Federal Reserve H.15 publication.
Five-year bond yield from CRSP Fama-Bliss data base.
Value-weighted NYSE/AMEX/Nasdaq stock return from CRSP.
S&P 500 dividend-price ratio from Robert Shiller’s web site.
Real consumption expenditures data for nondurables and servicesfrom the Bureau of Economic Analysis.
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Data and Summary Statistics Data
Output Gap and Price-Dividend Ratio
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Estimating Monetary Policy Rules
Estimating Monetary Policy Rules
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Model Calibration
Calibration ProcedureSpecify time-invariant vs. time-varying parameters to isolate effects ofchanging monetary policy and macroeconomic shocks (Smets andWouters, 2007):
I Time-varying parameters: Monetary policy rule parameters andvolatilities of shocks.
I Time-invariant parameters: ρ, δ, α, ρπ, ρx+, ρx−, λ.
Set monetary policy parameters to estimated values.Phillips curve parameters follow the literature: λ = 0.3 (Clarida, Gali,and Gertler, 1999) and ρπ = 0.8 (Fuhrer, 1997).Set leverage δ = 2.43 to match relative volatility of real dividendgrowth and real output gap growth, and utility curvature α = 30 tomatch equity volatility.Choose remaining parameters to minimize distance between modeland empirical moments:
I Slope coeffi cients and residual volatilities for a VAR(1) in log outputgap, inflation, Fed funds rate, and five-year nominal yield; volatilities ofbond and stock returns; and beta of bonds with stocks.
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Model Calibration
Model and Empirical Moments
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Counterfactual Analysis
Counterfactuals: MP Inflation Response and Persistence
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MP shocks and IS shocks contribute essentially zero to bond beta
PC shock lowers output and raises inflation:I Stock prices fallI Effect on bond yields depends on monetary policy regimeI Creates a positive bond beta in the first two regimes, a negative one inthe third.
Inflation target shocks raise inflation and nominal interest ratesI Inflation below new target.I Central bank lowers real rates, creating a boom.I Bond prices fall and stock prices rise, creating a negative bond betaI When monetary policy is persistent, central bank does not lower realinterest rates immediately but only with a long lag. Stronger effect onbond yields and bond betas.
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Partial derivatives reveal that:I Model equity return volatility driven by PC shocks.I Model bond return volatility driven by inflation target shocks and PCshocks.
Empirical volatility of equity and bond returns changed little acrossregimes.
I Model matches this with near-constant PC and inflation target shockvolatilities.
I Changes in the volatility of shocks cannot explain changes in bond beta.I Point estimates even have opposite sign.
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Conclusion
Conclusion
Fed anti-inflationary stance after 1979 increased nominal bond beta:I Large increase in Fed funds rate in response to inflation shockI Increase in Fed Funds rate depresses output, stock prices, and bondprices.
Persistent monetary policy (gradualism) and shocks to inflation targetgenerate negative nominal bond beta since mid 1990s:
I Inflation target shock decreases bond pricesI Real rates fall in response to inflation target shock, driving up outputand equity prices.
I Changes in offi cial central bank inflation target or central bankcredibility?
Phillips Curve (supply) shocks increase nominal bond beta, butmodest variation across regimes.
Changing risk premia offer important amplification mechanism.
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Additional Slides
Unconditional Variances
Unconditional variance equals conditional variance at zero output gap
Var(r et+1 − Et r et+1) = E[AeΣuAe ′(1− bxt )
]= AeΣuAe ′.
Investors in our model use this analytic unconditional variance toprice bonds and stocks.
I Report analytic unconditional variances and covariances.
Conditional variances can and do turn negative in calibration.I Model-implied unconditional variances lower than in a model whereconditional variances truncated below at zero.
I Similar results for alternative calibration in which conditional variancesalmost never go negative.
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